The transition management industry has changed dramatically in recent years. Major regulatory changes have taken place alongside an increase in trading complexity as the universe of counterparties and trading techniques expands continually. First in the US and latterly in Europe, the equity trading environment has also become more fragmented with the emergence of dark and light liquidity pools and rival trading platforms to existing exchanges, such as Chi-X. Trading, which is one of the key components of the success of a transition, remains as important as ever and, if poorly implemented, could add important costs to the overall transition. It is, therefore, crucial that transition managers establish the optimal trading strategy to restructure all assets and that the right tools are used during trade execution. In this new environment, transition managers must be able to combine risk and project management with best execution in compliance with the EU's MiFID (Markets in Financial Instruments Directive). Successful transition managers should be able to access all sources of liquidity (light or dark), crossing networks and various exchanges towards achieving best execution. To face these new challenges, transition managers have developed algorithmic trading platforms, mainly based on the implementation shortfall approach. These algorithms not only offer access to liquidity and best execution but also ensure client anonymity throughout the entire transition process. By carefully using the right trading tools, transition dealers are better able to control cost and risk while ensuring best execution to the clear benefit of the underlying client.
… transition trades should rarely pay a premium by
crossing the spread to be executed …"
Trading characteristics of transitions
Transitions have specific trading characteristics which must be captured by dealers when establishing trading strategies. Transitions are in essence a provider of liquidity to the market as they are long-term changes to investment strategies or may result from corporate restructuring decisions. Trading should therefore not be implemented with the aim of capturing short-term alpha, rather it should be executed passively to minimise the overall costs and risk of the restructuring of assets. In other words, transition trades should rarely pay a premium by crossing the spread to be executed and should, in some instances, benefit from a price improvement for providing liquidity to the market.
Another key characteristic of a transition is its benchmarking to a specific measure. The most commonly-used benchmark is the implementation shortfall method which measures the difference in returns between the actual portfolio held through the transition period and a theoretical, perfect transition into the target portfolio without commission, taxes or fees at closing prices the day before trading started (see Figure 1). Implementation shortfall is a comprehensive measure of transition cost and includes both explicit and implicit costs, such as market impact and opportunity cost, which account for the large majority of the overall cost of a transition. Other benchmarks such as VWAP or closing prices could be used as alternatives.
"Generating the optimal solution for a transition therefore involves ensuring you achieve best execution while balancing the objectives of minimising costs and risk."
For complex transitions, which might be implemented over a few days, weeks or months, these alternative benchmarks have some limitations; by not capturing the differential between the target and the current portfolios they will not be representative of the overall cost of the transition. For relatively straightforward restructurings, VWAP and closing prices will be appropriate measures to use as the transitions are done over a relatively short period (a couple of hours to a day).
The power of algorithmic trading
Transition traders have various tools - from single stock, portfolio or algorithmic trading to direct market access - to ensure best execution. The spectrum of choices varies from a 'high touch' approach (complex trades requiring manual intervention) to a 'low touch' method (less complex and more automated trades). Generating the optimal solution for a transition therefore involves ensuring you achieve best execution while balancing the objectives of minimising costs and risk. Obviously, it is not a case of one execution venue, technique and counterparty fits all. For example, large-cap names generally trade in large volumes and at a low overall cost relative to transaction size. It is our experience that in these circumstances algorithms are the most appropriate way to ensure best execution. A key strength of this approach is that it can allow transition traders to capture all specificities of a particular transition, including its underlying benchmark or level of aggressiveness, to derive an optimised trading solution. For relatively less liquid names, such as mid- and small-cap stocks, a more 'high touch' approach will be more appropriate.
Algorithms, by their very essence, are better at minimising the risk of trading a basket of securities, i.e. they are able to optimise the trading process by taking into account various market metrics, such as volume, momentum or volatility. Such techniques enable the portfolio risk to be reduced more quickly and efficiently than a manual trading strategy. The algorithms will identify the names presenting higher overall risk to the portfolio and start trading them earlier, to reduce their marginal risk contribution to the basket of securities. By reducing portfolio risk more efficiently, the trading window can be extended to allow a more passive approach to trading. Indeed, while each transition has different trading requirements, transition flows are usually considered 'low alpha' where possible, thus it is appropriate to allow a passive trading style as previously discussed.
This allows a reduction of market impact and can also help
maximise crossing opportunities. Algorithms are an ideal way to
capture this specific trading strategy.
The following example, which is based on a global developed equity transition, illustrates the benefits of using algorithms as a trading strategy. In this specific case, the transition team uses an optimal portfolio liquidation algorithm to manage the portfolio risk throughout the trading process. The charts opposite reflect the progress of the equity dealing required to support a specific restructuring of assets over a reporting period. Dealing was 91.7 per cent complete on day one as most liquid names were executed using our trading algorithm. Figure 3 indicates how the risk profile in the portfolio reduced in line with the transactions in the underlying equities. The tracking error was reduced from 2.13 per cent to 0.18 per cent after the first dealing day. This clearly demonstrates the power of algorithmic trading as an execution technique to reduce portfolio risk quickly and effectively to enable the transition dealer to concentrate on the more complex portion of the trade. In doing so, transition managers are better able to reduce the overall cost of the transition.
Access to liquidity
As previously mentioned, both the US and European equity markets
have become more fragmented in the last couple of years, with the
emergence of various liquidity venues (light and dark pools) and
alternative trading platforms (e.g. NYFIX's recently launched
Euro Millennium and, when it becomes available, Turquoise).
Transition managers in the EU must therefore be able to access
various sources of liquidity to capture optimal prices to ensure
best execution in compliance with MiFID.
The ability to use algorithmic trading gives transition managers the possibility to smart order route, which is essential in achieving best execution. This will give transition managers the opportunity to access internal/external dark liquidity pools as well as native and alternative exchange venues. Transition dealers should be able to control the way their various orders are managed by using a set of constraints, such as minimum order size to cross in dark pools, a cross limit price or the selection of venues to execute. If liquidity shifts to a single venue, smart order routing enables transition managers to move order flow to this venue in real time as well as working orders simultaneously on multiple venues.
Best execution is of paramount importance in the context of transitions. With an ever-expanding number of execution venues and a more complex trading environment, it is crucial that transition managers are able to develop the right trading strategy and that the right tools are used to implement an optimal execution. Algorithmic trading is not the appropriate trading solution for all transactions. For less liquid equities (e.g. small- or mid-cap securities) trading in low volume and at a high cost relative to transaction size, it is worthwhile engaging the skills of an experienced dealer and paying a higher commission rate as the overall cost of the trade will be lower. In this instance, trades will be done on a 'high touch' basis to deliver the optimal trade-off between risk and cost. To support this, transition managers should screen all trades for suitability to decide whether or not algorithmic trading is appropriate. If the stock is suitable, a broker's transition experts will recommend a high touch approach to ensure best execution.
to use algorithmic trading gives transition managers the
possibility to smart order route, which is essential in achieving
When selecting a transition manager, it is increasingly important to appoint a provider that has access to an established suite of algorithmic tools combined with a multi-broker execution platform.
Not as simple as it first appears?
There are a variety of tools available to transition managers to establish the appropriate trading strategy. Algorithms present clear advantages for relatively liquid names because they enable transition dealers to control risk better, access more liquidity and maintain anonymity to the clear benefit of the underlying client. The skill of the transition team consists in its ability to identify the optimal trading strategy and tools to minimise the overall cost and risk of the transition.